Company Dividend Policy

Company Dividend Policy

A companys shareholders are the most important capital suppliers to the firm, and financial decision making is aimed toward maximizing their wealth. One of the important financial decisions made within a company is its dividend policy; that is, the strategy the company uses to transfer cash to its shareholders. The module begins with some basic economics of dividends, showing how dividends can simultaneously be both the basis for share value and an irrelevancy. Actually, the argument is that the dividend decision, under certain idealized conditions, makes no difference to shareholder wealth, as long as other financial decisions (such as real asset investments and capital structure) are given. When those idealized conditions are removed, however, dividend policy may become important. When taxes, brokerage fees, consumption patterns of investors, and Information frictions are considered, dividend policy has the potential to be quite important. Introduction Most simply, the question of dividend policy is how much money the company should pay to shareholders across time. Dividends are the amounts of cash that a company distributes to its shareholders as the servicing of that type of capital. Shareholders have invested in the company by purchasing shares, and dividends are the companys direct compensation to shareholders for their investment. Dividends, unlike interest and principal payments to debt holders, are not a contractual right of shareholders. There is no requirement that a company pay its shareholders any particular amount of dividend at any particular time. However, since shareholders are the residual claimants of the companys cash flows, they do in a sense own the amounts of cash that the company produces net of all other contractual requirements (other claims being the costs of operations, taxes, interest, and so forth). Financial managers of a company must decide how much of its residual cash should be paid as dividends to shareholders. Since any residual cash not paid as dividends is still owned by shareholders, this retained cash is reinvested in the company on behalf of shareholders. The dividend decision is thus also, in mirror image, a cash retention or reinvestment decision. Any reasonable discussion of dividend polic y questions must treat both aspects of this decision. Our analysis of company dividend policy will assume that managers of companies try to make shareholders as wealthy as possible. So the

real question of dividend policy boils down to this: with amounts of cash that could be distributed to shareholders across time, and given that any amounts not so distributed would be reinvested by the company in the name of the shareholders, is there a particular strategy of dividend distribution that would produce more wealth for shareholders than any other?

Dividends and Market Frictions

Essentially three: taxes, transaction costs and flotation costs. Let us examine each of these in turn.

Taxation of Dividends
When a company pays a dividend, the cash thus distributed must make its way through whatever tax system exists in the economy before the dividend is useful to the shareholder. From the shareholders perspective, it is after tax (both company and personal) dividends that are of interest. Similarly, the substitute for dividends, capital gains, is also potentially liable for taxation. As we have argued many times before, tax systems are essentially arbitrary and can be quite different between countries. It is generally the case, however, that dividends are more heavily taxed than capital gains. In countries where the amounts of cash available to pay dividends are net of company taxes, and the dividends paid are taxed again at the shareholder level, dividend payment to taxable shareholders is expensive. Those shareholders would likely be better off receiving their wealth in the form of share price increases that are either not taxed or taxed at lower rates than the dividends. Suppose, for example, that companies pay income tax at the rate of 50 per cent and shareholders in addition pay 30 per cent tax on dividends received. Furthermore, suppose that a company has 1000 profit before tax (assume this is a cash amount) and is planning to invest 500 in assets during this period, so that 500 of cash must either be retained or raised from shareholders. The results of choosing to pay dividends or not are given in Table 1 below:

Table 1 - The Simple Corporation: changes in shareholder wealth due to investment Pay dividends Profit before tax Company income tax Profit after 1000 -500 Do not pay dividends 1000 -500 500

company 500

income tax Dividends Shareholder income tax Net after-tax cash 500 150 to 350 0 0 0

shareholders Increase in share value to 0 existing shareholders 500

In either case, the shares of the company will increase by 500, but should current shareholders receive the dividend, they cannot also receive the share price increase. It will go to the new shareholders who contribute the 500 necessary for the investment outlay. If the shareholders do not receive the dividend, they do receive the 500 share value increase because the company was not forced to raise cash from new shareholders, and because the money for the investment was retained instead of being used to pay the dividend. The important thing to understand about this illustration is that total taxes paid by the company and its shareholders are higher when dividends are paid than when they are not. Shareholders receiving the dividend have only 350 cash in hand after tax whereas they would have had 500 in share value had dividends not been paid. The company needs 500 for investment, and can raise that money from new or old shareholders. But the damage has already been done: the 150 of taxes is lost to government. When dividends are not paid, shareholders receive no cash, but neither do they pay taxes. Such shareholders paying no cash into the company, nor having others contribute cash, retain their full claim, and have a value increase of 500.

The difference between the final wealth of shareholders who receive dividends and those who do not is thus 500 350 = 150, the difference in the taxes paid. (If and when shareholders realize capital gains by selling shares, there may be some tax paid, but it is usually later and sometimes less than that paid upon the receipt of dividends.) In such a tax system where double taxation of dividends is unavoidable, there is a strong tax incentive against the payment of dividends for companies seeking to please their shareholders. (Interestingly, the empirical evidence as to whether high dividend paying companies shares are adjusted in price for the taxability of the dividends is mixed, or at least not agreed by consensus of researchers. Some think that in these economies there are enough dividend tax avoidance transactions available so that this tax detriment of dividends is really unimportant.) In some countries (such as the UK), dividends are not taxed as heavily. These imputation systems make some attempt to alleviate the double taxation of dividends by imputing an amount of company taxes to shareholders based upon the dividends that companies pay, and then giving shareholders a credit on their taxes for that amount. The effect of such systems is to cause less of a bias against dividends than systems that tax both company profits and shareholder dividends. Using the above example, assume that the tax system is such that dividends received by shareholders are imputed by tax authorities as having had 30 per cent tax already paid on their behalf by the company. Further, companies paying dividends pay the same total tax as companies not paying dividends, even though shareholders are given tax credits for the imputed tax on their dividends. Our example now becomes as in Table 2. Note two things about this example. First, shareholders receiving dividends pay no net tax on them, so that there is no wealth difference between the position of those who receive dividends and those who do not. The tax credit exactly matches the tax liability. (The reason that the liability and the credit are

Table 2 - Results of the dividend payment decision under the imputation tax system Pay dividends Profit before tax Company income tax Profit after 1000 -500 Do not pay dividends 1000 -500 500

company 500

income tax Dividends Shareholder income tax Tax credit Net after-tax cash 500 214.29 214.29 to 500 0 0 0 0

shareholders Increase in share value to 0 existing shareholders 500

more than 30 per cent of the dividend paid is the nature of the imputation calculation itself, wherein the dividends received are assumed to have been after the 30 per cent tax is levied, so that the dividend received is actually 70 per cent of the imputed dividend. The latter is taxed at the 30 per cent rate, meaning that the actual dividend generates a tax liability and credit of 30/70 of the cash amount paid.) Secondly, note that there actually is a tax liability on the part of the shareholder, against which there is a fixed credit. In this example, the tax and the credit are the same amount, so there is no net tax paid on the dividend and shareholders would be indifferent between receiving them or not. But suppose that there is a personal tax liability that is higher than the tax credit received (because of higher personal tax brackets b y shareholders). Here the credit would not cover the tax liability, and the shareholders would be worse off receiving dividends than not. Suppose also that shareholders personal income tax rates were 40 per cent. The situation now becomes as set out in Table 3

Table 3 - Results of the dividend payment decision for taxpayers in higher tax bracket Pay dividends Profit before tax Company income tax Profit after 1000 -500 Do not pay dividends 1000 -500 500

company 500

income tax Dividends Shareholder income tax Tax credit Net after-tax cash 500 285.71 214.29 to 428.58 0 0 0 0

shareholders Increase in share value to 0 existing shareholders 500

Here again there would be a bias against the payment of dividends, even in an imputation system. (In the UK there are further aspects of the company versus personal Dividend imputation system that produce a bias against dividend payments, having to do with the fact that the imputed shareholder dividend tax is paid in advance. Advance corporation tax (ACT) must be paid by the company even if there is no company income tax. The company can set this off against its income tax mainstream corporation tax (MCT) if and when this is eventually paid. You are familiar enough with the time value of money to see the penalty involved when a company with no income tax liability pays dividends.)

Transaction Costs of Dividend Payments

The second friction with which dividends interact is transaction costs. Recall the example of the Simple Corporation. There, company dividend policy affected not the total of shareholder wealth but the composition of that wealth. Higher dividends meant

more cash and less value, and vice versa. From the perspective of shareholders, if they can costlessly shift their portfolios from shares to cash and back, there is no reason to prefer one payment to the other. For example, suppose Simple had chosen to reduce its dividend so as to make the investment outlay. Shareholders would, relative to the opposite decision, have found themselves with 100 000 less cash, and 100 000 more share value. If shareholder preferences were to consume some of that 100 000, they would merely sell some shares for cash. (If they sold exactly 100 000 worth of shares, they would put themselves in the same situation that they would have been in had the company instead paid them the dividend and sold shares.) The opposite would have been true had the shareholders received a dividend but wished to consume only part (or none) of it. They would then have costlessly converted the cash into shares. So in the Simple Corporation, dividends did not matter. But in real markets, shareholders cannot shift costlessly between shares and cash. There are usually brokerage fees to be paid when such transactions take place. (And there may be the forced realization of capital gains and the taxes thereby due.) So shareholders may prefer one dividend policy to another depending upon their preferences for consuming wealth across time and the costs they would pay to achieve the desired consumptio n pattern, given a particular dividend policy by the company.

Flotation Costs
Finally, companies themselves incur costs in raising money from capital markets when they pay dividends so high as to require new shares to be sold. These are called flotation costs, and they can be significant for the issuance of new shares, depending upon the mechanism of sale. If intermediaries such as investment bankers are used, the costs can be as high as 5 to 25 per cent of the total value of issued shares.

Combined Frictions
So real market considerations of taxes, transaction costs and flotation costs are potentially significant considerations for companies in their dividend policy decisions. Though the sizes and impact of these frictions are essentially an empirical question, and

can differ in different countries, it is probably true that the net bias in most cases is against the payment of cash dividends and toward the retention of cash by the company. Given the average tax brackets of shareholders and other empirical elements of these frictions, the result of substituting capital gains for dividends is diminution of transaction and flotation costs, and delay or reduction of taxes. The resulting optimal dividend policy of companies would be as follows: find all of the investments that have positive NPVs, and retain as much cash as is necessary to undertake these investments; if there is cash left over, only then might a dividend be paid; only raise new equity capital when internally generated funds are insufficient to pro vide the cash necessary to undertake all good investments. This is sometimes called a passive residual dividend policy. If our discussion of dividends were complete, we would expect to see evidence that companies actually pursued such a policy. What we see instead is that companies dividends across time are much more stable than a passive residual policy would require. We also would expect to see the shares of companies that pay relatively high cash dividends valued less highly than otherwise identical companies who instead tend to retain cash. The evidence here is mixed, and not overwhelmingly in favor of retention as we would expect. Why do companies not follow a passive residual strategy of dividend payment? Probably because passive residual dividends are not the best option for companies. (Either that or companies are not aware of the frictions discussed above, which is unlikely.) If passive residual dividends are not optimal, our discussion of dividend decisions cannot be complete. There are evidently additional factors to be considered in the dividend decision.

Other Considerations in Dividend Policy

Dividends and Signalling
One of the empirical findings about company dividends is that these cash payouts seem to be more stable in monetary terms across time than any particular residual or clientele hypothesis for dividend policy can explain. Company financial managers seem to be loath to pay a dividend unless they think it can be sustained for some period of time by

the expected cash flows of the firm. This seems to be true even when the company would be retaining cash beyond its current need for investment funds. And in other instances, companies simultaneously pay a cash dividend and sell new shares, an obviously expensive combination. How can this be explained? One obvious explanation is that company financial managers do not understand the arguments about company dividend policy that we have made up to this point in the text. In a competitive market for financial managers, however, that would not be a very convincing argument. There must be something else afoot. One explanation for the smoothing across time of company dividends that seems more reasonable is the signalling value of dividends. The argument for signalling goes as follows. Real financial markets have frictions not only in the form of transaction costs, brokerage fees and taxes, but also in the free flow of information. Companies find themselves operating under various constraints in informing

shareholders about the future prospects of the company. And it is in the interest of shareholders that shares may be bought and sold at prices that fully reflect this information. These constraints take the form of restrictions on public forecasts of cash flows by managers by the accounting profession through its generally accepted accounting principles, through government regulatory provisions in company security issuances, through the fear of litigation being brought by disappointed share purchasers should the forecasts prove incorrect, or through the fear that competitors will receive valuable information about the companys plans, thus reducing the value of those plans. Yet it is obviously in the interests of managers and shareholders to have share prices reflect new information as quickly as possible. (This is true even when it is bad news, because you are likely to fool the market only once or twice by hiding or delaying bad news, and thereafter would have a difficult time getting good news believed.) How then might shareholders be informed of events that cannot be explicitly broadcast? This can take place through subtle signals that the company gives by alterations, for example, in its dividend payment. There is evidence, though by no means conclusive, that companies do just that when changing dividends. It is now easier to see why dividends must be reasonably smooth over time. If, for example, a company pursued a policy of paying as much cash dividend as possible (a widows and orphans policy), the time

pattern of dividends would be driven by the occurrence of residual cash across time. For most companies this is likely to be a rather random process. And it is difficult to the point of impossibility to signal information by changing dividends if the base pattern from which the signal is to be interpreted is random. The same would hold true for any other clientele based policy. So one reason for the smoothing of dividends across time is that the dividend announcement can be made to be a surprise (either good or bad) to the market. Based upon the past pattern of dividends (either with respect to time or relative to other measures such as earnings), the market will have developed an expectation for the dividend to be announced. If the announcement is higher than expected, the news is good; if lower, bad. The phenomenon of signalling can also explain certain financial market actions that have no good reason to exist otherwise. Consider, for example, the transaction called a share dividend. Here a company declares a dividend, but does not pay cash to its shareholders. Instead, each outstanding share is paid an additional partial share of the company. For example, if you hold one share of Complex Corporation, and the company declares a 10 per cent share dividend, you will now own 1.1 shares of the companys equity. That sounds fine, until you remember that all shares of Complex received the same dividend. Therefore the transaction is completely neutral with respect to shareholdings. The company has more shares outstanding, but each shareholder has exactly the same proportional claim on the companys cash flows as they did before. A moments thought will produce the inescapable conclusion that there is no obvious reason for companies to do this (especially since there are transaction costs involved). Now, however, we can offer a reason for share dividends to exist. They can be used as a signal, just like cash dividends. There is convincing evidence that companies use these transactions (including share splitting wherein a two for one split is the same as a 100 per cent share dividend) to signal to shareholders, and that shareholders pay attention to and act upon these signals.

Dividends and Share Repurchase

On occasion a company may repurchase its shares on the open market. When that is done, the company will also usually announce that the transaction is being undertaken

so as to have shares for various uses (merger and acquisition purposes, employee stock option exercise, and so forth); very often the company will announce that it considers its shares underpriced and thus a good investment, and is therefore investing in itself. The first set of reasons is a bit suspicious, because there is seldom a reason why the company could not simply issue new shares to employees and merger candidates instead of going to the trouble to repurchase. The latter reason (a company investing in itself) is rubbish, and the company knows it. No one is really fooled by these pronouncements accompanying share repurchases by companies. Why then are such transactions undertaken? And why are these announcements made? The truth is that share repurchases are nothing more than a cash dividend to shareholders. If all shareholders sell back to the company the same proportion of their holdings, it is easy to see that the net effect is to shift cash from the company to shareholders, leaving undisturbed the proportional claim of each shareholder. Even if all shareholders do not sell their shares to the company in the same proportions, you can see by our earlier discussion about opposite personal portfolio transactions that shareholders can end up having the same proportional claims after the repurchase if they so choose. This would be accomplished simply by buying or selling shares among themselves on the open market, using the money that the company distributed. What of the claim of investing in itself? A company can no more invest in itself by repurchasing its shares than a snake can successfully nourish itself by chewing upon its tail. Eventually truth will out. There will always be a 100 per cent equity claim outstanding as long as there is one share not repurchased, and since that single share would claim the entire firm, it would take the entire equity value of the company to repurchase it. This exposes share repurchase for what it truly is: a payment of cash dividend (or, in the extreme, a liquidation of the company). Does this mean that company share repurchases are to be scorned and avoided as duplicitous? Not at all. Remember, the market is never fooled by such transparent statements. Why then are such actions taken? One reason is that in some countries the money received by shareholders in share repurchase transactions is taxed more lightly (or even not at all) in comparison with cash dividends declared by the company. Obviously it is bad public relations for a company to announce that by share repurchase it is seeking to help its

shareholders avoid paying their income taxes on dividends. So the announcement of investing in itself is made. Share repurchases on the open market also show some signs of being signalling attempts that receive a positive response from shareholders. There is one type of share repurchase that is not so positive for shareholders, however. In some countries a company can undertake a targeted share repurchase. This is a transaction wherein a company offers to repurchase only particular shares (usually held by an individual or group which the companys managers are frightened will take over the company and make things less pleasant for existing management). The repurchase price is usually at a significant premium above the existing market price of the companys shares. And the shares of the company on the open market usually decline in price even more than would have been expected by the loss of the cash premium paid. Evidently the market thinks that targeted share repurchases are bad news for shareholders, in that existing managers will now be left to make decisions about the company without the implied oversight of the external market for managerial talent evidenced by the now bought out shareholdings.

Conclusion
The discussion of dividend policy in this module has run the full gamut from a clear, simply analyzed decision in perfect financial markets to a very complex process with many different alternatives and tactics available to the company in its wish to maximize shareholder wealth. We have seen that in frictionless financial markets (without taxes and transaction costs, and with the free flow of information) dividends make no difference. We have also seen that no markets are really so frictionless, and that there is at least the possibility that shareholders may prefer one dividend policy to another because of real frictions that are experienced. Companies, however, in seeking to maximize shareholder wealth can be expected in aggregate to have offered the market the mix of dividend policies that clears the market of potential share premiums for any particular dividend policy, even in the presence of dividend clienteles. That leaves us with the notion that dividends are not really irrelevant, but that marginal gains from switching dividend policies are unlikely, and may even be costly to shareholders.

Finally, we saw that dividends may be used as signals by managers to shareholders for information that would be expensive to disseminate otherwise. That may cause companies to smooth their dividends across time more than a basic wish to serve a particular clientele would suggest. Such signals could also be accomplished by many other techniques, such as share dividends instead of cash dividends. Though these are the main ideas about company dividend policy, they are not exhaustive of all the implications of company dividends for shareholder wealth. For example, one effect on the dividend a company declares might be that the debt the company has issued has a legal restriction on the amount of dividend that a company is allowed to pay. (And companies may pay less than the maximum allowable dividend in some years so as to build up a reservoir of allowable dividends should they face a time of plentiful residual cash and few positive NPV investments.) There are those who think that dividends also play a role in the problem of conflicts of interest between shareholders, managers and creditors. These are called agency considerations. The payment of cash dividends can be regarded as a shifting of control of these assets from managers to shareholders, the latter then having the option of whether or not to allow managers to regain operating control over such assets. This may constrain managers to behave more in the interests of shareholders. Dividends can be used to shift assets out of the company and therefore from the potential claim of creditors. Dividend payments can also change the overall riskiness of the companys asset base. Both of these can be detrimental to creditor wealth, and creditors will doubtless take pricing or contractual actions to offset these potential uses of dividends. Company dividend decisions are thus not the simple process of deciding how much cash is left after all commitments and plans have been executed, and paying that amount to shareholders. The considerations of signalling, agency and the effects of market imperfections upon optimal dividends are important dimensions about which financial managers must be aware.

www.letsknowsomething.blogspot.com

www.pics4u-saini.blogspot.com

asksachinsaini@gmail.com

thanks